‘Very real danger’ that the eurozone crisis about to flare up again

Cyprus: Eurozone crisis in danger of flaring up

Europe is once again facing the spectre of brinkmanship this week as a crucial vote to approve a bailout for Cyprus is set for Tuesday.

The vote will see Cypriot President Nicos Anastasiades attempt to secure enough support to implement a bailout package that was designed to save Cyprus from a disorderly default. The €10-billion package, which was proposed over the weekend, is expected to involve taxing the bank accounts of ordinary citizens in an effort to shore up enough money to keep Cyprus solvent.

The eurozone’s decision to part-fund a bailout of Cyprus by taxing bank deposits drove down shares, the euro and the bonds of its troubled sovereign debtors on Monday.

Hopes that the tactic will not be used elsewhere later helped to contain financial market losses.
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“Cyprus could face the dire consequences of a disorderly default on sovereign debt in June [without the bailout],” warned IHS economist Chuck Movit. “A default, furthermore, could lead to an exit by Cyprus from the Eurozone.”

Roughly €1.42-billion in four-year sovereign bonds will become due in June, and Cyprus has said it does not have the money to pay back its bondholders.

Under a bailout package that would allow the country to make that payment, Cypriot depositors with funds less than €100,000 would be on the hook for a 6.7% tax, while those with more than €100,000 would pay a 9.9% tax.

The current situation can be traced to the 50% haircut Greek bondholders received in 2011, a move that devastated many of Cyprus’ banks and their large holdings in Greek debt. The Cyprus Popular Bank had €3.4 billion in Greek government debt when the haircut hit in 2011, while the Bank of Cyprus had €2.4 billion. The two banks ended up losing €2.5 billion and €1 billion, respectively, which led to the Cypriot government’s nationalization of Popular Bank last year.

The proposal to tax bank accounts, however, has shocked many as eurozone officials had previously said that bank deposits would not be touched. Mr. Movit said the bank levy could open up a “nasty can of worms,” with the biggest concern being that savers in other struggling eurozone countries could start to fear they’re next.

“[The risk is] depositors will feel increasingly uncomfortable about leaving their money in banks in these countries,” he said. “This could then lead to a destabilizing withdrawal of credit from banks that exacerbates the problems and further escalates the problem.”

While many Cypriots took to the streets Monday to protest the current package, the government said it may explore an alternative package that would increase the tax load on the wealthy and possibly spare those with deposits under €100,000. Cyprus’ central bank currently insures all bank deposits up to €100,000, which would make an altered package easier for the country’s savers to swallow.

Eurozone finance ministers released a statement Monday night saying they support treating depositors with less than €100,000 in cash different than those with more, saying they reaffirm “the importance of fully guaranteeing deposits below €100,000.”

Not everyone is convinced that the Cyprus bailout in its current form is a misstep, however. Willem Buiter, economist at Citi, said that despite the initial fury, the program represents a positive for Europe and is unlikely to be replicated anywhere else.

“Contagion risks are overrated, in our view,” he said, noting that prior to the bailout, Cyprus’ banking system was on the verge of collapse.

“The risk of bank runs in other euro area countries has clearly risen, but the unique features of the Cypriot situation should limit the ‘read through’ to other cases in the euro area,” Mr. Buiter said. “Even when bank runs occur, the European Central Bank has the means to substitute for the funding lost from departed deposits.”

After an early sell-off, stock markets around the world took the news in stride on Monday. While North American markets were down, the Dow and the S&P 500 saw marginal dips of only 0.43% and 0.55%, respectively. In Toronto, the TSX declined 0.38%.

But while the market reaction was relatively muted Monday, John Higgins, economist at Capital Economics, warned that a failure to pass the package or even a delay could spark a new bout of stock volatility this week.

“The return of fears that Cyprus (and other countries) may actually leave the euro-zone altogether if the latest deal is rejected by the Cypriot parliament could lead to a sustained correction in the prices of equities more generally, as well as other risky assets,” he said.

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